The birth of a new child and … MONEY
Monday, November 2nd, 2009 by Cass Chappell, CFP®
A comparison of popular gifting strategies
Summary:
· If the gift is meant to be used in 18 years (in the case of a college education) or more, I tend to favor strategies that are more aggressive and have the potential for a greater return
· I will usually try to talk you out of buying a life insurance policy as a gift
· 529 plans (and Coverdell Education Savings Accounts) offer a tax benefit but are restrictive in how the funds may be used
· UGMA accounts (Uniform Gifts to Minor Act – also known as UTMA or Uniform Transfers to Minors Act) are much less restrictive in how the funds may be used.
· The tax benefits of a 529 plan couple with the flexibility of an UGMA account may lead you to consider using BOTH
On October 19th I welcomed my first child, Olivia Hyland Chappell, into the world. At 7 pounds, 7 ounces (21 inches) both mom and baby are doing great.
Parents and grandparents frequently ask about savings programs for children. The idea of creating wealth for the new loved one is very appealing. Paying for college education or providing a little “seed money” for an eventual down payment on a home seem to be the most cited objectives, in my experience.
There are many tools that are readily available. Let’s examine a few.
Life Insurance
This used to be one of the most popular financial gifts for newborns. A small policy, with guaranteed cash value was purchased shortly after the birth of a child. When the child reached 18 or 21, the policy would have cash value which could be accessed via cashing the policy in, or the policy could be continued indefinitely. In many cases, the policy also contained a provision allowing the purchase of additional insurance when the child turned 18 or 21 (for example).
· This strategy was easy to implement. Back then (I am talking about the early 90’s and prior), everyone knew how to get in touch with a life insurance agent
· The premiums were usually very small
· Since it was life insurance, there was no ongoing tax reporting (as long as the policy wasn’t cashed in)
· If monthly premiums were undesirable, the parent or grandparent could usually pay the entire premium in advance
· If the child died prematurely, there would be a sum of money available to provide for a funeral
Some drawbacks
· Cash value accumulation is often at a rate comparable to a CD or savings account. BUT, it is usually guaranteed
· The death benefit is constantly being eroded by inflation. My grandfather purchased a $5000 policy for me when I was born. At that time (1974), it was more than the average annual salary of an American worker. By the time I was an adult (1999), I would need at least 40 times that much insurance to provide for my family.
529 Plans
I wrote about 529 plans recently, and even though they aren’t perfect, they are still worth considering.
· The money grows tax deferred and is ultimately tax free, if it used for qualified college education expenses
· The beneficiary of the account can be changed (if necessary), allowing for the gift to benefit multiple people or if a child earns a scholarship or doesn’t go to college
· The parent usually retains control of the money….even after the child reaches adulthood.
· Funds withdrawn for non qualified expenses are subject to a 10% penalty and income tax
· The investments in 529 plans are usually much more aggressive and involve more risk than a CD, savings account, piggy bank, or life insurance policy…….but this is a good thing
Some drawbacks
· Accessing the money for anything other than qualified college education expenses will trigger a penalty and income tax
· The potential tax benefits must be weighed against the restrictions in the use of the money
UGMA Account
This account provides the most flexibility for the child. Using both an UGMA account and a 529 plan is completely acceptable and may be a smart idea.
· Money can be used for any reason, at any time, as long as it is for the benefit of the child
· These accounts can be easily opened at most financial institutions
· Virtually any type of investment can be used
Some drawbacks
· Accounts receive unfavorable financial aid status once the children apply for college
· Kids can take control of the money upon reaching adulthood (18 to 21, depending on the state)
For the most ambitious parents and grandparents, we might recommend a combination of both a 529 plan (for college) and an UGMA account (for general wealth building).
